Social foundations of Institution and

Development

Yardstick International College (YIC)

2022
• Background on the nature of institutions
• Need for the theory of institutional analysis
• The need to go beyond existing economic
theories to improve performance
Introduction

• Institutionalism is an approach to the study of social,

economic and political phenomena.
• It is argued that Institutions structure are
interrelations: they enable individuals to understand
what other individuals are doing, what they are
likely to do, and what may and may not be done.
• An institutional perspective sees the world as
institutionalized with institutions acting as
mechanisms for change, linking causes and effects
What do we know about good economic
performance?
• Statistical evidence about economic
performance is available for countries around
the world
• Economic growth and development are a
function of an economy’s productivity.
• Higher productivity requires better
institutions
Institutions are necessary for
productivity and economic growth
• Well defined property rights
• Political institutions defining legal rules
• Judiciary serving as a third-party enforcer of
contracts and agreements
• Level playing field of equal rights and legal
protection for everyone
• BUT knowing the kind of institutions that need to be put in place to
realize economic growth does not tell us how to acquire them in
the first place
Why do we need the theory of
institutional analysis?
• The institutional approach into the study of
economics is originally introduced as a reaction to
Neoclassical Economics;
• Neoclassical economic theory does not address
how to create efficient markets
• Focuses on already developed markets
• Does not explain the role of political markets
Assumptions of neoclassical school

• perfectly rational traders

• full information
• well-defined and stable preferences
• homogeneous goods and services
• Unbounded rationality
• self-interested actors
• zero transaction costs (transaction hurdles)
• information search, inspection, negotiation and bargaining, decision
making and cost of making wrong decisions, monitoring and
enforcement
• “Pareto efficient” exchange equilibrium
Problems with the neoclassical theory
assumptions
• Frictionless markets (they “just work” without
governments or institutions)
• Static policy implications (not accounting for time,
history, or the way humans learn)
• Ergodic world view ( world with a constant
underlying structure of the economy, like in natural
sciences)
 We live in an evolving, complex,
and non-ergodic world
• The world is dynamic in continuous change ,
• From the perspective of economic history, we are
constantly creating new and novel worlds
• The types of problems humans faced in the past are
not the same we face today
 Another perspective: public goods and…

• Strictly defined, pure public goods have two salient characteristics:

• non-excludability (namely it is not desirable and not feasible to exclude people
from their consumption/benefits once the goods or services are provided) and
jointness of supply
• (or non-rivalry, meaning that an increased consumption by one member of the
society does not diminish the consumption of the others).
• Collective action problems occur not only when consuming but also when
providing public goods to a group of people.
• Nonetheless both properties of pure public goods constitute a parable of
collective action, which can be best depicted by the well known game
theoretic Prisoners’ Dilemma (PD) model.
• This paradoxical situation has been widely used for the explanation of
collective action problems in many branches of social sciences.
 …Collective action problems

• The concept of public goods: a symbolic formulation of the so-called

collective action problems (or the social traps in other words), which are
closely connected to the co-operation of the latent groups in large
numbers and the problem of free-riding.
• The former idea means that the individual is lost in large-sized groups, any
of his/her activity or possible contribution to the things of the community
is "marginal", that is unnoticeable.
• This latter idea means that according to the (narrowly) rational or in this
case short-sighted, self-interested individuals, it is not worth contributing
to the production of the public good because others will do that anyway.
• But if others provide the public good, nobody can be excluded from its
consumption, as we have learned before and there is a big temptation to
free-ride.
• According to game theory free-riding is a dominant strategy: since the
individual player is better off in any case regardless of the fact what others
do. In this way, however, they will not provide themselves the public good.
 Two-player, one-shot PD game

• In a two-player, one-shot PD game, rational individuals even if they

would mutually benefit from cooperation will fail to do so because there
is a big temptation to defect if we look at the payoff matrix. (Next slide)
• If both players cooperate, they each receive a payoff 3.
• If each defect, a payoff 2.
• Whereas if only one player cooperates, the cooperator gets the worst
payoff, only 1,while the defector gets the highest payoff, 4.
• Thus there is strong incentive for both of them to defect, and indeed,
defection is a “dominant strategy” for each player, because each obtains a
higher payoff no matter what strategy the other player chooses.
• However, while choosing the strategy of defection promises an
individually higher payoff it finally leads to a mutually less preferred,
Pareto-suboptimal (or inferior) outcome (Defect-Defect).
 Cooperate Defect

Cooperate 3, 3 1, 4

Defect 4, 1 2,2
• If red cooperate blue want to defect because 4>3
• If red defect blue want to defect because 2>1
• Therefore, defect is the dominant strategy for blue

• If blue cooperate, red want to defect because, 4>3

• If blue defect, red want to defect because, 2>1
• Therefore, defect is the dominant strategy for red

• Defect, Defect will be the final solution, (sub-optimal)

 Mancur Olson’s collective action problem

• According to Mancur Olson, many theoreticians had implicitly and explicitly accepted the
view that groups of individuals with common interests usually attempt to further those
common interests, stemmed from a logical deduction of the premise of rational, self-
interested individuals’ behavior.
• However, Olson rejects this argument, saying:
• it is not in fact true that the idea that groups will act in their self-interest follows logically from the
premise of rational and self-interested behavior.
• Unless the number of individuals in a group is quite small, or unless there is coercion or some other
special device to make individuals act in their common interest, rational, self-interested individuals
will not act to achieve their common or group interests.
• In other words, even if all of the individuals in a large group are rational and self-interested, and
would gain if, as a group, they acted to achieve their common inters or objective, they will still not
voluntarily act to achieve that common or group interest.
• Furthermore, such large groups will not form organizations in order to achieve their common goals
in the absence of coercion of separate (from future achievement) incentives. What makes this
situation worse is the fact that even in the case of unanimous agreement in a group about the
common good and the methods to achieve this, collective action will not take place to further the
common goal.
 The social trap is closed…
…how to get out?

• Thus we reached such a social trap or a collective action problem, where the
interests of the individual and the community are in contrast to each other,
because in a case where everybody takes into account only their own, short-
term self-interests, and in addition, the contribution of the individual is
negligible, the production of the public good is pretty doubtful.
• Such a social trap in its broader sense is the general election, for instance,
where the vote of each individual is lost in the multitude and "does not
have any influence", so it is unnecessary to go to the polls, but if everybody
thinks in this way, then after all, nobody (or just few people) go to the polls
in a local or governmental elections, and a tiny part of the community
decide the fate of the whole finally.
• So the question is given: how can we get out of this social trap?
 Solutions to the problem

• The message of the Prisoner’s Dilemma and consequently of the

collective action game has been as “depressing” as challenging,
therefore many social scientists have tried to solve the problem. The
basic question is what kind of mechanism can induce the rational,
self-interested players to opt for the cooperative solution of the
game?
• Remaining within the game-theoretic framework there have been many
attempts to solve the paradoxical situation of the Prisoner’s Dilemma.
• The earlier mentioned self-defeating outcome is due to the fact that the
original PD game is one-shot, therefore one of the solutions is making it
“iterated”. If the number of plays is “infinite”, or at least it is uncertain
when it will end, there is a great chance for cooperation.
 „Tit-for-tat” strategy

• Robert Axelrod has demonstrated in a computer tournament that the so-called “tit-for-
tat” strategy (cooperating in the first round then doing whatever the other player did on
the previous move) in repeated games was the best strategy that lead to a Pareto-optimal
solution.
• It was the winner because it was the simplest and the "nicest", meaning never being the
first to defect. See his argument, in a nutshell:
• the pre-condition for the evolution of cooperation is that the players have a sufficiently large
chance for future interaction.
• If this is met then cooperation can evolve. According to Axelrod, under certain conditions the
actors of the “game” can learn to cooperate.
• When people recognize that they have objectively common interests and there is a high
probability of future association cooperation will more likely occur, as in the First World War
trenches, the so-called “live and let live” type of cooperation.
• In another computer simulation model scientists found that in a population with a local
interaction structure, where individuals interact with their neighbors and learning is by way
of imitating a successful neighbor, cooperation is proved to be a stable strategy that cannot
be easily eliminated from the population.
 External (or institutionalized) solutions

• External (or institutionalized) solutions are those, where the “rules of the
game” are changed, meaning peoples’ possibilities, attitudes and beliefs
are changed (but not necessarily from outside of the group).
• External solution can either be centralized or decentralized depending on
to what extent the initiative for the changes is dispersed amongst the
members of the group.
• A centralized solution, for example, if it is concentrated in the hands of
only a few members of the group, as in the case of “the state”. In Thomas
Hobbes’s Leviathan can be found the first full expression of the
justification for the existence of the state Leviathan, as a metaphor,
constituting laws and order, necessarily do play a primary role in resolving
social dilemmas (discussed later).
• However, this is not the only way!
 „Governing the Commons„ in communities

• Communities on the other hand, are characterized by decentralized

solutions.
• Community is a group of people
• Who have beliefs and values common
• Whose relations are direct and many-sided, and
• Who practice generalized as well as merely balanced reciprocity
• Elinor Ostrom, in her "Governing the Commons" (1990) book, provided
alternative solutions to the strongly recommend state and market ones in
common-pool resource (CPR) problems by examining how communities try to
“govern their commons” by voluntary organizations.
• "Success in starting small-scale initial institutions enables a group of individuals to build on
the social capital thus created to solve larger problems with larger and more complex
institutional arrangements.„
 Political entrepreneurs
• External solutions are not necessarily “coercive”, restricted to the use of threats
and offers, positive or negative sanctions, because altering the expectations of
people (through, for example, persuasion) can also be treated as an external
solution, therefore political entrepreneurs belong to this group.
• Anyone can be a political entrepreneur who offers his/her services to solve or
remove the collective action problem in exchange for a „profit” (which can be a
material or monetary reward, but also an immaterial political support from a
constituency e.g.)
• Such an entrepreneur can establish a collection organization, gather
contributions, or provide the public good itself. In these cases the crucial
function of the entrepreneur is to provide different mechanisms for pooling
resources.
• Political entrepreneurs can serve as coordinating mechanisms, not only by
collecting and distributing information but also by manipulating the expectations
of the individual members of the group regarding the behavior of the other
members
• Can alter group members’ sense of efficacy concerning their own contribution to
the public good. In this way, they can play the role of an “advisor” or
“intermediary “ among the group members “.
 Internal or spontaneous solutions

• Internal or spontaneous solutions are those, which “neither involve nor

presuppose changes in the game”, i.e. all those factors that induce members a
group to voluntarily act for the collective good, meaning that cooperation can
evolve without any external force.
• Internal solutions help individuals living in communities to develop such rules
and mechanisms that later become institutionalized (external) solutions, as
“ready tools” for future conflict resolution.
• Relying on the achievements of experimental social psychology, sociology and
economics the following motivations are included: self interest or egoism,
altruism, collectivism and principlism.
• Besides these motives, we consider trust, as another essential and necessary
factor of cooperative behavior.
 What is trust?

• Some theoretical questions, which cut to the core of an unsettled debate among social
scientists: What are the sources of trust and trustworthiness? If social norms are part of
the reason for the presence of trust, how can it be manufactured? How can trust be
introduced into an antagonistic situation?
• Can cooperation come about independently of trust?
• Can trust be a result rather than a pre-condition of cooperation?
• How can trustworthiness be acquired?
• Some say that “apart from teaching children the capacity to trust others (largely
being trustworthy to them), there is little point in cultivating trust ”, because “law
and political institutions are used on behalf of trust, they should be used to cultivate
trustworthiness and to block the kinds of actions that would most severely abuse
trust”
• However others claim that normal social relations require a background or
atmosphere of normative commitments to be honest and to keep promises namely
an atmosphere of trustworthiness.
• To make and maintain such an atmosphere, however, one needs laws and institutions
that safeguard against the “abusers”.
 Trust and cooperation,
a „chicken-egg” problem?

• Game theory suggests the so-called “tit-for-tat” strategy in repeated games under certain
conditions can lead to a Pareto-optimal, cooperative solution of the PD. What is essential is to
avoid the use of “defect all” strategy by announcing to play a "nice tit-for-tat” in the very first
round, that is to cooperate.
• Nevertheless just announcing is not enough, something more is needed to take it seriously.
There should be an initial, mutual trust between the playing partners and a credible
commitment from the side of the starter to keep his word.
• Diego Gambetta doubts that the “Axelrodian” spontaneous evolution of cooperative behavior
can evolve without trust. He argues that the tit-for-tat strategy is “inconceivable in relation to
humans without at least a predisposition to trust: when the game has no history a
cooperative first move is essential to set it on the right track, and unconditional distrust could
never be conceived as conducive to this.”
• What is more, some have reservations that cooperation could be associated with trust at all,
because in this game theoretic case, cooperation results rather from continuous calculation of
self-interest than a mutually recognized suspension of such calculation. One could rather
speak about a modus vivendi than trust.
 Studied trust

• Yet another approach suggests that in close communities, with strong norms, and/or
common history and cultural heritage one can find the basis of trust. The City of London
or the community of diamond merchants provide good examples of this. Nonetheless
the same problem arises as before: how was the initial trust created? Trust is a by-
product of events which, to the extent they are planned at all, did not have the creation
of trust as their goal”.
• Then how to solve this fundamental problem of creating trust? Charles Sabel tries to
provide us with an explanation based on the notion of the “reflexive self”. In contrast to
the neo-classical and neo-liberal accounts of the self from which stems the pessimism
about the possibility of trust, Sabel contends that there is nothing mysterious – at least
in principle – about the creation of trust.
• “The reflexive self, which on this account is the one we actually have, can entertain and act on the idea of
creating or extending common values regarding loyalty and forbearance in the face of vulnerability
precisely because it knows that other selves can entertain and act on the same idea. Whether and under
what conditions such a change is likely to occur is an empirical question… Mutual dependence is the
precondition of both individuality and sociability, is in some sense known to be such” .
 Trust is a “thick and thin” human relation

• These reflexive selves form a community, which by definition is prudent and other regarding,
where a “trusting world” is imaginable for all.
• Moreover, this belief is constantly tested and encouraged by the help of different devices that
are the part of a continuous process of collective self-definition in a mutually dependent
world.
• Trust is a “thick and thin” human relation, because people deliberately make themselves
vulnerable to others and are also capable of doing so, but due to their deliberation, they can
place trust anywhere they want.
• Therefore “blind trust” and “undying loyalty” are rather deformation of this kind of human
relation where making and breaking trust are inevitable phenomena. Present cooperative
relations do not presuppose future obligations because there is always the possibility of
placing trust elsewhere.
• Continuous self-definition and reinterpretation allow room both for debates and their
resolution, thus seemingly – and sometimes really – throat cutting feuds (or just
misunderstandings) can be settled. This kind of “genesis amnesia” can provide an answer to
the presence of the strong social cohesion of some communities (like in “close communities”
mentioned before).
• This process can either be called a “negotiated loyalty”, “studied consensus” or “studied trust”.
By the help of this “process of studied trust ”the pitfalls of both the game theoretic and the
historical/cultural explanations can be avoided.
 Learning by monitoring

• Nevertheless cooperation means entering into a vulnerable position,

thus such a risky move requires creating such governance structures
that allow for constant monitoring and consultation. According to Sabel
the more deliberately the parties apply the general principles of
cooperation to their particular activities, the more effective those
activities will be. As he observes, monitoring can serve as routinizing
contact between different parties.
• Similarly Ostrom stresses, analyzing the development of self-governing
institutions, that "learning is an incremental, self-transforming process
• The supply of trust increases rather than decreases with use, and trust
can become depleted if not used!